Mind The Euro Basis Swaps------Trouble Brewing In Draghi-Land

By David Stockman. Posted On Saturday, March 28th, 2015

An Accelerating Trend

While the euro itself has recovered a bit from its worst levels in recent sessions, euro basis swaps have fallen deeper into negative territory. In order to bring the current move into perspective, we show a long term chart below that includes the epic nosedive of 2011. We are not quite sure what the move means this time around, since there is no obvious crisis situation – not yet, anyway.

A negative FX basis usually indicates some sort of concern over the banking system’s creditworthiness and has historically been associated with euro area banks experiencing problems in obtaining dollar funding. This time, the move in basis swaps is happening “quietly”, as there are no reports in the media indicating that anything might be amiss. Still, something is apparently amiss:

Party like it’s 2011: Three month, one year, three year and five year euro basis swaps – click to enlarge.

Worries About Greece?

It is possible that concerns over Greece find expression in this rather obscure market – apart from the Greek government bond market itself that is. The Greek yield curve remains steeply inverted, with 2 year notes yielding 20.14%, 5 year notes yielding 15.47% and 10 year bonds yielding 11.19%. Such steep yield curve inversions have been a typical feature of sovereign debt crisis conditions in the past. Greece’s bond yields are actually slightly below recent peaks, as the Tsipras/Merkel meeting has briefly rekindled hopes.

However, the Greek government is indeed running out of money – it has adopted all sorts of stop-gap measures to keep the ship afloat, as a result of which it is now running out of those as well. The ECB meanwhile has tightened the screws by making a drip-feed operation out of ELA and telling Greek commercial banks that they are no longer allowed to increase their holdings of Greek government bills.

EU officials are reportedly discussing the possibility of Greece being forced to impose capital controls (similar to what happened in Cyprus) if the government misses any upcoming debt repayments. The ECB’s recent decisions have been justified by a) the prohibition of direct central bank financing of governments and b) its need to limit its exposure because it appears as though Greece may not come to an agreement with its creditors after all.

Time to pry further aid tranches from the wallets of its creditors is running short for the Greek government. It will very soon have to present a reform plan that pleases the EU, something it has not been very adept at so far. Bondholders have every reason to be worried. 5 year CDS spreads on Greek sovereign debt have recently jumped to 1,840 basis points, moving up by 110.50 bps in a single day yesterday. This implies a very high default probability (CPD: 78.95%). By comparison, 5 year CDS spreads on Cypriot government debt stand only slightly above 500 bps at present.

Greece, 5 year government bond yield – short term volatility is largely driven by news flow, but the larger trend looks definitely ominous – click to enlarge.

If Greece were to exit from the euro, the euro area could well emerge stronger, as its weakest link would be gone. The problem is only that the often repeated assertions about the euro’s “irreversibility” would no longer be credible, since a Greek exit would ipso facto prove that euro membership can indeed be reversed.

However, European banks have scarcely any exposure to Greek government debt anymore, which has by now been largely shifted to assorted tax payers. They may still have to write off some loans to the private sector though and could fall victim to whatever fallout ensues if a Greek default actually occurs. Another potential problem are dollar-denominated loans extended by euro area banks to emerging market borrowers, as many EM currencies have plummeted relative to the dollar.

Many of these assets are therefore likely on shaky ground. Consider the case of the Swiss franc: In Austria, Hypo Alpe Adria Bank’s successor Heta (a “bad bank” that is tasked with winding Hypo’s assets down) just wrote off 85% (!) of its outstanding CHF loans, as a result of the SNB ditching the minimum exchange rate. This leads us to suspect that dollar loans extended by euro area banks to EM borrowers with plunging local currencies could prospectively be in far worse shape than is generally assumed.

Speculation in Euro Futures

Speculators meanwhile are holding a massive net short position in euro futures. Although the standardized futures market is small relative to the size of the total FX market, it definitely tells us something about overall sentiment and positioning. It can be seen as akin to a poll; although it is a comparatively small market, the information conveyed by its structure is nevertheless statistically significant.

Below is a chart of the net commercial hedger position in euro futures, which is the inverse of the net speculative position (big and small speculators combined).

Speculators continue to bet heavily against the euro. Their net short position (the other side of the net long position of hedgers shown in the chart) remains close to its previous all time highs, which were reached when talk of the euro’s imminent demise was rife everywhere – click to enlarge.

This large bet against the euro is potentially vulnerable. For one thing, the Greek problem may yet be resolved by a resumption of the giant “troika” (sorry, “institutions”) extend & pretend scheme. For another, euro area macro-economic data have strengthened of late, while US macro-data have weakened rather noticeably. So far this development has been ignored by FX traders, but that doesn’t necessarily mean they will keep ignoring it. If perceptions about the likely duration of the current central bank policy divergence were to change, a great many well laid plans would stand to be revised quite suddenly.

On the other hand, the Greek situation evidently represents a sizable event risk for the euro, though we hasten to add that the currency’s reaction to a “Grexit” is not set in stone. It could well become a “sell the rumor, buy the fact” situation. Incidentally, the event has recently been renamed “Graccident”, i.e., “Grexit” by means of misfortune dispensed by the Fates. Under this new terminology, it would no longer be anyone’s fault; obviously a blessing in disguise from the perspective of the politicians/bureaucrats involved.

Among the three Fates, Atropos is currently the most dangerous to Greece, on account of the Fates’ division of labor: Clotho spins the thread, Lachesis measures it, and Atropos cuts it.

Image via Wikimedia Commons

Conclusion

Something is odd about the recent move in euro basis swaps. Last time a a similar move occurred, there was a palpable sense of panic in the markets, with European bank stocks plunging, bond yields in peripheral euro area countries soaring and gold rising to almost $2,000/oz. The only similarity this time is the weakness of the euro (which is even more pronounced than in 2011/2012). Other than that, the markets don’t seem very concerned, given that yields in e.g. Spain and Italy are sitting at record lows and European stock markets are strong.

There are certainly concerns about Greece, but they seem strangely subdued and isolated (Greek stocks and bonds are obviously doing badly). We can be fairly certain though that the soaring dollar represents a problem for a great many borrowers, many of whom happen to be clients of European banks. We plan to continue to keep an eye on this and will post updates if anything momentous seems to happen.

The euro has a small bounce – quite possibly of the dead cat variety. However, the large speculative short position remains vulnerable to a change in perceptions – click to enlarge.

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